Investing in stocks carries certain risks. Apart from market risk, anybody investing in stocks of foreign companies is also exposed to currency risk – the reality that currency conversion rates fluctuate in time. Since US companies currently make around 60% of investable world equity (Nov 2021), this seems especially concerning for non-US investors.
It sounds bad, and the active management industry likes to build on the fear and offer currency-hedged products (for a beefy fee, of course). But is currency risk really that bad and should it be avoided whenever possible? We will offer a few reasons why that might not be the case.
• Exposure to currency fluctuations doesn’t always increase volatility. As shown in the study [1] by Vanguard, depending on the correlation between exchange rates and equity returns, currency “risk” may reduce volatility. This might be caused by investors flocking to “safe haven” currencies like USD during crises. In that scenario, while the value of equities in USD falls, the USD strengthens.
• Currency hedging is a zero-sum game (before fees), and long-term currency exposure usually has little effect on equity returns [1].
• Since the future value of equities is not predictable, hedging is always only approximate. In the words of Rob Carrick, “Hedging is like playing hockey with a baseball bat. It can be done, but the results are clumsy.”
• While the US is currently the largest equity market by far, the sources of revenues for the global companies are much less US-centric: less than 30% of global revenues come from the US, the rest is split between Emerging countries (42%), Europe (17%), and Developed Pacific countries (11%) [2]. If a USD hedge is considered, this should be reflected. Fragmented revenue streams make hedging challenging.
• Currency risk hedging might be expensive, especially when:
• correlation between a country’s equity returns and the value of its currency is negative, which is recently the case for the US (the “safe haven” case) [3]
• The government bond yield of the foreign country is higher than the bond yield of your country. This is the case of Eurozone investors who have hedged their US investments in the past decade.
• Imperfect hedging, extra fees, and expenses often show in large tracking errors. The CanadianCouchPotato [4] offers a few concrete examples.
• The curency risk is not symmetric. If the local currency weakens significantly compared to USD and you are fully hedged, you are in a really bad spot. If the local currency strengthens significantly compared to USD and you are not hedged, it is still manageable for many people who have other money streams in (now strong) local currency from salaries, side gigs, government pensions, etc.
A few more related points:
• Unlike equities, foreign currency exposure does significantly increase bond volatility, and it’s generally a good idea to currency hedge foreign bonds.
• The currency which you use to buy an instrument is irrelevant in this discussion. It doesn’t matter if the ETF you buy is denominated in USD, EUR, or Banana Republic Dollars. What matters is the companies whose shares you own, and the sources of their profits.
Equity hedging might make sense sometimes, given that it is approached with moderation. But it isn’t as straightforward decision as we are often led to believe, and I wouldn’t worry too much if my equities weren’t currency-hedged at all (they aren’t).
Relevant CSI and RR episodes: CSI - Should You Currency Hedge Your Portfolio?
Resources: [1] https://personal.vanguard.com/pdf/ISGPCH.pdf [2] https://www.msci.com/www/blog-posts/accounting-for-revenue-sources/02235 [3] https://www.pwlcapital.com/sp-500-etfs-to-hedge-or-not-to-hedge-that-is-the-question/ [4] https://canadiancouchpotato.com/2010/05/05/international-tracking-error-part-3/
** Disclaimer This material is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax or investment advice or an investment recommendation, or as a substitute for legal or tax counsel.